How types of market differ, and why it matters

1. How types of market differ, and why it matters Michael Joffe Imperial College London PKSG, Cambridge, November 2011

2. Structure of the talk • the current discourse: • the market vs. the state • market failure • real-economy competition between firms: • cost-tethered markets • cost competition • free-floating markets • a model of bubbles • rationality • conclusions

3. Structure of the talk • the current discourse: • the market vs. the state • market failure • real-economy competition between firms: • cost-tethered markets • cost competition • free-floating markets • a model of bubbles • rationality • conclusions

4. The current discourse I • a large part of economic theory concerns the properties of “the market” • central to this is, under certain assumptions, “the” market has a particular set of properties: convergence towards a stable equilibrium (and under certain conditions, Pareto optimality) • observation: not all economic phenomena can readily be explained using this framework – most recently bubbles/crises; but also the specific property of capitalism, that it grows • exogenous technical change, or smithian growth

5. The current discourse II • criticisms typically focus on the assumptions being unrealistic, or on market failure of various types, e.g. monopoly power, missing or incomplete markets, externalities, public goods or information asymmetry • “failure” => the market does not work as the theory would predict (i.e. the theory itself is OK) • more broadly, the discourse is one of “the” market versus the state – with a political dimension, in which theory is evaluated largely in the light of one’s political values

6. Types of market I • the term “types of market” has a number of possible meanings: • place: local, national, international • time: very short, short, long, very long period • the ideal types of textbook theory: perfect competition, monopoly, duopoly, oligopoly, monopolistic competition, monopsony • different types of goods: inferior, luxury, Geffen, positional goods; winner-take-all markets

7. Types of market II • various arbitrary divisions, e.g. • physical, internet, labour, intermediate goods, stock market, ad hoc auctions, illegal markets, ... • financial markets, currency markets, futures markets, the money market (lending/borrowing) • consumer, industrial, commodity and capital markets

8. Types of market II • various arbitrary divisions, e.g. • physical, internet, labour, intermediate goods, stock market, ad hoc auctions, illegal markets, ... • financial markets, currency markets, futures markets, the money market (lending/borrowing) • consumer, industrial, commodity and capital markets • I argue: different types of market have radically different dynamic behaviour, for reasons that can be readily understood, and this can be modelled

9. Structure of the talk • the current discourse: • the market vs. the state • market failure • real-economy competition between firms: • cost-tethered markets • cost competition • free-floating markets • a model of bubbles • rationality • conclusions

10. Structure of the talk • the current discourse: • the market vs. the state • market failure • real-economy competition between firms: • cost-tethered markets • cost competition • free-floating markets • a model of bubbles • rationality • conclusions

11. Real-economy competition between firms I • with goods and non-financial services, costs play a large role in price setting • prices are set in the market, in response to the levels of supply and demand – as always

12. - quantity supplied A quantity demanded A price A - // profit/incentive

13. Real-economy competition between firms I • with goods and non-financial services, costs play a large role in price setting • prices are set in the market, in response to the levels of supply and demand – as always

14. Real-economy competition between firms I • with goods and non-financial services, costs play a large role in price setting • prices are set in the market, in response to the levels of supply and demand – as always • competition tends to drive the price down

15. - quantity supplied A quantity demanded A price A - // profit/incentive

16. - quantity supplied A quantity demanded A price A - - // profit/incentive intensity of competition

17. Real-economy competition between firms I • with goods and non-financial services, costs play a large role in price setting • prices are set in the market, in response to the levels of supply and demand – as always • competition tends to drive the price down

18. Real-economy competition between firms I • with goods and non-financial services, costs play a large role in price setting • prices are set in the market, in response to the levels of supply and demand – as always • competition tends to drive the price down • costs set a limit to how low prices can go – they cannot go below unit costs for long

19. - quantity supplied A quantity demanded A price A - - // profit/incentive intensity of competition

20. cost A - quantity supplied A quantity demanded A price A - - // profit/incentive intensity of competition

21. Real-economy competition between firms I • with goods and non-financial services, costs play a large role in price setting • prices are set in the market, in response to the levels of supply and demand – as always • competition tends to drive the price down • costs set a limit to how low prices can go – they cannot go below unit costs for long

22. Real-economy competition between firms I • with goods and non-financial services, costs play a large role in price setting • prices are set in the market, in response to the levels of supply and demand – as always • competition tends to drive the price down • costs set a limit to how low prices can go – they cannot go below unit costs for long • the result is, prices tend to end up just above unit costs – the difference is the mark-up • I call this cost tethering • it is not rigid: the mark-up is variable

23. cost A - quantity supplied A quantity demanded A price A - - // profit/incentive intensity of competition

24. cost A - quantity supplied A quantity demanded A price A - - // profit/incentive intensity of competition A SYSTEM WITH COMPENSATING (NEGATIVE) FEEDBACK – IT TENDS TO MOVE TOWARDS STABLE EQUILIBRIUM

25. e.g. a “supply shock” – a cheaper source of a mineral cost A - quantity supplied A quantity demanded A price A - - // profit/incentive intensity of competition

26. e.g. a “demand shock” – a successful promotion campaign cost A - quantity supplied A quantity demanded A price A - - // profit/incentive intensity of competition

27. e.g. a “supply shock” – a cheaper source of a mineral e.g. a “demand shock” – a successful promotion campaign cost A - quantity supplied A quantity demanded A price A - - // profit/incentive intensity of competition THESE PROCESSES OCCUR OVER TIME, BUT ARE STATIC IN THE SENSE THAT THE ONLY TIME-DEPENDENT ENDOGENOUS PROCESS IS TOWARDS A STABLE EQUILIBRIUM

28. cost A - quantity supplied A quantity demanded A price A - - // profit/incentive intensity of competition

29. cost A - quantity supplied A quantity demanded A price A - - // profit/incentive intensity of competition profit/incentive \\ - quantity demanded B quantity supplied B - price B - cost B

30. PRICE COMPETITION cost A - quantity supplied A quantity demanded A price A - - // profit/incentive intensity of competition profit/incentive \\ - quantity demanded B quantity supplied B - price B - cost B

31. Real-economy competition between firms II • so far, I have assumed costs as given – as is conventional in mainstream theory • what happens if costs can be reduced?

32. Real-economy competition between firms II • so far, I have assumed costs as given – as is conventional in mainstream theory • what happens if costs can be reduced? • this would necessarily be on a longer timescale, via investment

33. COST COMPETITION via investment // cost A - quantity supplied A quantity demanded A price A - - // profit/incentive intensity of competition profit/incentive \\ - quantity demanded B quantity supplied B - price B - \\ cost B via investment

34. The standard market equilibrium model S price D P1 Q1 quantity

35. Cost competition S1 S2 price D P1 P2 Q1 Q2 quantity

36. Cost competition S1 S2 price D S3 P1 P2 Q1 Q2 quantity

37. Cost competition S1 S2 price D S3 S4 P1 P2 Q1 Q2 quantity

38. Cost competition S1 S2 price D S3 S4 P1 P2 S5 Q1 Q2 quantity

39. The core institution of capitalism • the way this has happened historically has been by control of the means of production, plus employment of wage labour – the capitalist firm • this provides flexibility in the inputs it can call upon and in the size of the market it can supply • the firm can readily introduce new technology/ production methods and/or new products • the capitalist real economy, far from being “a market economy”, is dominated by market relations between firms – a hybrid: competition between authority structures

40. Cost reduction and capitalist growth • the fall in unit costs, i.e. real input, for the same output is equivalent to an increased output for the same real input – one source of growth • the other source of capitalist growth is the introduction of new/better quality products • these account for the dynamism of capitalism: “capitalism is unique in the extraordinary growth record it has been able to achieve” (W Baumol) • so: institutional change → system characteristics → specific endogenous causal processes

41. Arms race model I τA‘ = – κAτA + ρAτB + αA τB‘ = – κBτB + ρBτA + αB τA and τB represent annual expenditure on future cost reduction; τA‘ and τB‘ are 1st derivatives κA and κB represent constraint on expenditure, ρA and ρB represent the response of each company to the other αA and αB represent the animal spirits of each firm

42. Arms race model II if κAκB > ρAρB:

43. Arms race model III if κAκB < ρAρB:

44. Simulations (in Vensim) • a productivity change is introduced: 10% fall in costs • each run represents a different scenario: • baseline run, before productivity is altered (black line): everything is stable – all lines are horizontal • innovation in a pre-capitalist economy, with no capacity to reduce costs (blue line): like the baseline, except for the initial Effect on unit cost A – a one-off effect (step change) • competition between a capitalist and a non-capitalist firm (red line): “company” B is unable to respond to company A’s cost-cutting, leading to its relative decline • with capitalist competition, in which both companies can reduce costs (green line): the arms race leads to greater changes in both firms than the original 10% change in productivity, and which continue indefinitely

47. Structure of the talk • the current discourse: • the market vs. the state • market failure • real-economy competition between firms: • cost-tethered markets • cost competition • free-floating markets • a model of bubbles • rationality • conclusions

48. Structure of the talk • the current discourse: • the market vs. the state • market failure • real-economy competition between firms: • cost-tethered markets • cost competition • free-floating markets • a model of bubbles • rationality • conclusions

49. Markets that are not cost-tethered I • not all markets are cost-tethered; these can be called free floating: the price depends only on what the potential buyer and seller can agree • the main examples are in the financial sector, e.g. the stock market, but also collectibles (Baumol): there is no “natural” price to which actual prices gravitate, nor is there a unit cost that tethers the price • price setting is thus highly dependent on what information is available • commonly this is trend extrapolation

50. Markets that are not cost-tethered II • those could be called “capital” markets • real estate is similar, but the dynamic is slightly different because a boom stimulates new construction; property booms are typically accompanied by a financial boom • markets in commodities (e.g. minerals) have unit costs, which adjust slowly in response to price changes; futures are free-floating • both could be regarded as aspects of “land” • bubbles: self-fulfilling prophecy (+ve feedback)